Profiting from Health-Care Cuts?

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Increasing attention to the use of accounting gimmicks to boost profits has rekindled a nine-year-old controversy involving Financial Accounting Standards Board Statement No. 106. In recent months, critics have renewed charges that some companies are using FAS 106 — the standard that since 1993 has governed accounting for postretirement health-care benefits — as part of a strategy to reduce retiree medical coverage, then reflect the lower reserve amounts in operating earnings. While there is evidence to support the suggestion in some cases, the issue is far more complex.

The FAS 106 issue mirrors criticism of FAS 87, which funnels surplus pension assets through corporate income statements as a credit to pension expenses. Some companies, critics charge, then slash their pension benefits to help keep the surpluses pumped up.

"The mechanics of FAS 87 and FAS 106 are almost identical," says J. Richard Hogue, an actuary specializing in FAS 106 valuations. That's because both standards were designed to ensure that companies record liabilities for retirement benefits in the years employees were working to earn those benefits, according to "the key principle of accrual accounting: to match revenues and expenses," notes Julia D'Souza, assistant professor of accounting at Cornell University's Johnson Graduate School of Management. D'Souza argues that FAS 106 "offers a relatively cost-free means for managers to achieve desired financial reporting objectives."

Here's how the technique supposedly works: Under FAS 106, companies record their accrued liability for postretirement health benefits and other nonpension benefits, after making a series of assumptions about health-care cost trends, inflation, retirement age, mortality rates, employee turnover, and other variables. "The accounting rules require companies to disclose the principal underlying assumptions" so that investors "can assess the accuracy of the estimated liability," says Eli Amir, a U.S. and international accounting standards scholar who now heads Israel's accounting standards board. Still, the wide range of variables can allow a company to tweak its expectations any number of ways, and affect earnings favorably.

The APBO Election

When FAS 106 was adopted, it gave companies a choice. They could record their unfunded, previously unrecognized accumulated postretirement benefit obligation (APBO) as a single, one-time nonrecurring charge, or they could record it through smaller charges taken over as many as 20 years. (Companies formed since 1993 account for postretirement benefits on an accrual basis.) Accounting rules require that if a company adjusts its estimated liability downward after taking a one-time APBO hit, the difference must be amortized as a credit that flows through to the bottom line. "At the time, it was posited that some companies would recognize the APBO in one fell swoop, and then, through a series of negative plan amendments, bring the already-recognized obligation into earnings over time," says Jane Adams, an accounting and tax analyst in Credit Suisse First Boston's equity research group.

Indeed, this is what happened in the three years between approval of FAS 106 and its effective date. Some corporations recognized the entire accumulated liability and then dramatically reduced retiree health-care benefits, citing the standard's impact on their financial statements. McDonnell Douglas Corp., for one, terminated health-care benefits for its nonunion employees as of January 1993 — just after its 1992 recognition of an accumulated liability of $2.48 billion. (McDonnell Douglas is now a part of Boeing Co.)

There is "a strong statistical link between the decision to recognize the full liability in the first year and the decision to make negative plan amendments in subsequent years," says D'Souza, co-author of the paper "The Use of Accounting Flexibility to Reduce Labor Renegotiation Costs and Manage Earnings." Of companies studied for the paper, 62 percent adopted FAS 106 using the immediate-recognition method. Of those, 14.2 percent later made negative plan amendments, reducing retiree benefits.

In contrast, only 7.1 percent of the companies that amortized their APBO reduced benefits, which "supports the view that the timing decision was deliberate," says D'Souza. The research also "shows that firms with strong labor unions had a greater tendency to recognize the entire accumulated liability in one shot," adds John Jacob, an associate professor at the University of Colorado, Boulder, and another of the paper's co-authors.

In D'Souza's view, in fact, FAS 106 "was simply the scapegoat." She believes that well before the accounting rule change was proposed, companies knew "that they needed to cut retirement health benefits, and they just used FAS 106 as an excuse."

Aiming above the Line

Critics charge that companies have another incentive for recognizing the entire FAS 106 obligation all at once. Investors tend to discount this kind of below-the-line charge, and it generally does not affect executive compensation. Any credits that appear within earnings, reflecting amortization of a reduction in the liability estimates, would be above the line, potentially aiding executive pay along with the stock price.

"By immediately recognizing a large liability and then gradually wiping it off, management can claim that it turned the company around, and ask for 20 million more stock options," says Phyllis Borze, an attorney at O'Donoghue & O'Donoghue, in Washington, D.C., and a professor at George Washington University's School of Public Health, also in Washington. "But it hasn't added any real value to the company." At the same time, of course, the company may have been reducing medical benefits for its retirees.

In the case of Caterpillar Inc., to cite one example in the "Accounting Flexibility" paper, a one-time pretax charge of $3.39 billion was taken for 1992. In the same year, the Peoria, Illinois, heavy-equipment maker amended its retiree health plan to establish coverage caps and tighten eligibility. When it amortized the more than $1 billion in liability reductions, as the accounting rules require, Caterpillar claimed a $104 million credit in postretirement medical expenses in 1992, and larger credits in five subsequent years. These credits boosted pretax earnings per share by an average of 49 cents annually through 1998. Had Caterpillar instead amortized the $3.39 billion medical benefit liability, leaving benefit levels unchanged, annual pretax earnings would have been lowered by at least 93 cents a share over those six years, according to D'Souza. In fact, she says, the 93 cent estimate is understated, because it ignores the effect of the plan amendments on such expense components as service cost and interest expense. (Caterpillar confirms the 49 cent pretax number, but says it doesn't understand how the 93 cent reduction was derived.)

Despite the case made by D'Souza and Jacob that some companies use FAS 106 to smooth out earnings, some experts maintain that the overestimates of projected liabilities in 1992 were generally little more than incorrect guesses, often reflecting conservative accounting practices. "Companies believed that it was safer to overestimate the liability than to underestimate it," says Anna Rappaport, a principal at benefits consultant William M. Mercer in Chicago. "They knew that with so many companies in the same boat in 1992, the equity market was likely to ignore a big one-time hit to earnings." But if a company underestimated the accrued liability, and was forced to recognize additional amounts in later years, the stock-price penalty might have been significant.

"It was the usual accounting tendency, to get the bad news out of the way," says Jeffrey Petertil, an independent actuary who advised the Financial Accounting Standards Board as it was drafting FAS 106. "Companies reasoned, 'As long as we have to record a number that's going to shock everybody, we'd better not underdo it,' " he says.

Elisabeth Rossman, vice president of benefits for Sears Roebuck & Co., in Hoffman Estates, Illinois, explains that from the big retailer's perspective, "the large initial estimates were based on the high rates of medical inflation that existed in 1992." Indeed, the health-care industry was experiencing double-digit annual inflation then, so the $2.9 billion liability Sears established for FAS 106 "was appropriate," according to Rossman. And "when health-care cost increases slowed in the mid-1990s, it became our fiduciary responsibility to revise our estimate downward," she adds, noting that "a lot of companies had the same experience."

Most health-care consultants agree that it was virtually impossible to foresee the deceleration in health-care cost increases that occurred in the mid-1990s. "No one — not even the government — foresaw the extent of the decline," says Frank McArdle, a health-care consultant with Hewitt Associates.

A Matter of Economics

While health-care cost increases moderated during the mid-1990s, costs have risen by more than double the rate of general inflation since 1998, and should climb 11 percent this year, according to Mercer. Prescription drug costs alone rose 17.5 percent in 2000. "Retirees tend to use prescription drugs a lot more than the working population," says McArdle, "and Medicare is not paying any of the cost for outpatient drugs." In addition, the retirement-age population has grown dramatically in recent years. Together, these factors have made retiree health benefits a particular target for some companies.

"U.S. companies are under a lot of pressure to bring their costs in line with competitors that do not have these expenses," says Mercer's Rappaport. "If they don't make the necessary adjustments to stay competitive, they will underperform in the stock market and get bought out. This is why companies are reducing benefits — not FAS 106."

Indeed, some experts suggest that FAS 106 provided a wake-up call about the magnitude of the costs associated with retiree benefits. "I think some companies were genuinely clueless about how much these benefits were going to cost them over the long haul," says Ben Neuhausen, a partner in Arthur Andersen's professional standards group. "Once Statement 106 forced them to measure these obligations, a lot of companies realized that they had offered benefits they could not afford."

Of course, there's also the question of whether companies should have been more careful not to present their benefits as promises to employees, when the reality is that corporations reserve the right to reduce or terminate coverage at any time. Perceiving their benefits to be iron-clad pledges, employees often plan for their retirement on that basis. Then, employer benefit cuts leave them lacking the expected coverage, adding real injury to what otherwise might have been a relatively academic FAS 106 accounting debate.

Laurie Kaplan Singh is a freelance writer based in Winnetka, Illinois.

FAS Footwork

Companies that took a one-time charge under FAS 106 were more likely to cut retiree health benefits.

Percentage of sampled companies taking APBO in one charge: 62

Of those, percentage later making negative retiree medical-plan amendments: 14

Percentage of those amortizing over 10 to 20 years: 38

Of those, percentage later making negative retiree medical-plan amendments: 7.1